Defensives out of fashion

Fund managers and analysts are beginning to warn that so-called defensive stocks now carry higher risks.

Investors have flooded into defensives – tobacco, telecoms, pharmaceuticals, food retailers and utilities – in the past few months in search of a safe haven.

These stocks are usually believed to do well during a recession, as they supply the essentials that people always need, such as water and healthcare.

But fund managers are now warning that some of these stocks are looking overpriced – while others are turning out to be not so defensive after all.

While defensives have had a good run, outperforming the market in the last part of 2008, they have begun to lose some of their value in recent weeks, leading some fund managers to argue that the time has come to exit.

“I think there are a lot of investors who are hiding in this area rather than proactively investing,” says Mark Costar at JO Hambro Capital Management.

“Investors have had a pretty traumatic year with falling markets and that’s led to a complete trouncing of risk-taking. They’re looking for dividend security at any price and that’s what’s driven up valuations above fundamental value. But as investors notice the deteriorating fundamentals, that’s leading to rotation out of the shares,” he explains.

Defensives have been announcing a spate of bad news in recent weeks, causing their share prices to wobble further.

A number of food companies that are normally seen as ultra-defensive, such as Unilever and Kraft, have issued profit warnings this year.

Then, earlier this month, both Unilever and GlaxoSmithKline said they were no longer going to give profit guidance to the market.

Meanwhile, water companies are battling on two fronts. Their prices are linked to inflation, so in a deflationary environment they will struggle.

And the sector was hastily sold off at the end of January when Severn Trent said the effect of businesses using less water during the recession was hurting its profits more than it had expected.

The slowdown in emerging market consumer spending is also ringing alarm bells over consumer stocks.

“If you look at consumer staples like food producers, tobacco and beverage stocks, the three pillars of growth are emerging market growth, consolidation and consumers trading up,” says Costar. “Our contention would be that each of those three pillars is under threat.”

Costar also warns that tobacco companies may be vulnerable because of their exposure to emerging markets, adding that Imperial Tobacco is very highly geared.

But whether to continue holding defensive stocks depends very much on an investor’s risk profile. For those who believe the outlook for the economy is set to stay gloomy for some time, it may simply be worth paying the premium.

“The more safe you think they are, the more you’re willing to pay for them – so you have to ask whether it’s worth paying for the safety,” says Jonathan Jackson at Killik & Co.

“I would say the food and drinks companies – Unilever, Diageo, Reckitt Benckiser – are probably overvalued, especially given that they may not be as defensive as we thought.”

Pharmaceuticals are seen as much cheaper. Astra Zeneca is trading on a forwards price/earnings (p/e) ratio of 7 for this year with a yield of 6 per cent, compared with Diageo which is on a p/e of 13.

So Killik has been moving out of the more expensive defensives and into pharmaceuticals.

Many of these still offer the best income around. Now that banking stocks are defunct for income-seekers and interest rates on cash are close to zero, defensives are offering very strong yields of 6 per cent or more.

Hugh Yarrow at Rathbones says: “We are relatively defensively positioned because we run income mandates and to do that you need resilient cash flow, so naturally you’re led to defensives like utilities, oil and consumer staples.”

However, he is wary of pharmaceuticals because their products have a short life cycle – many of their drug patents expire in the next couple of years, which could harm profits.

Some are holding defensives for growth as well as income. “I would argue we will look back and think it was a great opportunity to buy some quality companies at great prices that will continue to build their cashflow,” says Yarrow, citing Diageo and Unilever as examples.

But others are seeking to diversify their risk, as defensives are less likely to outperform the market if it starts to rise again.

“Last year, the trade was just being in defensives – I’m not sure it’s so clear-cut any more,” says Martin Cholwill at Royal London Asset Management. “It probably makes sense to have a broader industry spread at the moment.”

Those who think defensives are overpriced are considering a move into cyclical stocks – which tend to outperform as the market rises.

One stock favoured by fund managers is Burberry. Graham Kitchen at Henderson likes the company because it has low debt and is trading on cheap multiples.

JO Hambro managers are also taking advantage of what they call supply-side shifts – buying companies that are profiting from others going into administration – such as HMV, the music retailer, after the fall of its rival Zavvi.

However, Kitchen cautions: “The risk is selling out of defensives too early. Even ultra-defensive food stocks have been hit by declining growth but they have more security in earnings than the rest of the market, so it’s probably too early to say you have to buy cyclicals now.”